Back to the Future
in Financial Risks of Banking
- A Dimensional Test Approach
Murthy Yerraguntla
Srilatha Ganapati Vasu
Nagendran N
Infosys Limited (NASDAQ: INFY)
Abstract
Today’s banking world faces the toughest challenges than any industry and they must
take calculated risks to outshine the competitors. Failure to balance between risks and
profit results definite catastrophe in terms of financial liability, stakeholders wealth and
trust. This is precisely why the Financial Risk Management and control has gained more
prominence in the recent past. It has become one of the core disciplines to identify
measure and monitor profile of the banks. Supervisory Committees such as Basel have
been coming up with more rigorous control measures to safeguard the banks and
stakeholders from the pangs of financial risk.
Every financial player in the market must provide accurate and timely updates to the
regulatory bodies and abide by the rules of compliance. In order to comply with this,
banks rely upon software applications to generate reports and assure the risks are
hedged appropriately. Testing plays a crucial role in ensuring that the various risks have
been thoroughly analyzed and observations are reported to management.
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Abstract (cont..)
This tutorial highlights the progression in the profile of a tester during the
implementation of Basel Accords. It envisages the potential role of QA during the
implementation of Basel III
Contents of the tutorial will elaborate on
• Types of critical risks being encountered by Banks
• Regulatory bodies like Basel Compliance (II & III)
• Approaches to monitor risk (Standard, Internal and Advanced)
• Various tests to analyze the risk appetite (Stress testing, Back testing)
• Roles played by QA during the first 2 Basel Accords
• Progression in the profile of QA during Basel II
• Anticipated role of QA during Basel III
• Best practices
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Target Audience
This tutorial can benefit:

Test Managers : To comprehend the potential role of QA during Basel III
implementation

Test Leads/Engineers : To recognize the relevance of dimensional testing
approach while validating the risk applications

Beginners: To showcase how exciting the QA role in the field of risk is going to
be in future --
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Outline of the Tutorial
5. Transformation of QA profile during
Basel II (20 mins)
1. Scope of QA during Basel 2
2. QA Phases
1. Objective & Expectation (5 mins)
1. Objectives of the session
2. Expectation from Audience
2. Introduction of Financial Risk (15 mins)
1. Types of major Risks
2. Sub Categories of Risk and Measurement
approaches
3. Major financial failures post Great depression
6. Anticipated Role of QA during
Implementation of Basel III (15 mins)
1. Introduction to Basel Capital Accord III
2. QA with Key Objectives of Basel III
3. QA at the end of Basel III
3. Introduction to Basel and Role Of Quality
Assurance (10 mins)
1. A brief history of Basel committee
2. Basel I Capital Accord
3. Basel II Capital Accord
7. Best Practices (15 mins)
1. Best Practices
8. Summarization (5 mins)
1. Quick Re-cap
4. Transformation of QA profile during Basel I
(10 mins)
1. Scope of QA during Basel 1
2. QA Phases
9. Closure (10 mins)
1. Revisit the objectives
2. Q&A
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Objectives, Expectations…

Objectives of this session : Is to touch upon the concepts of risks and role of QA
while validating the risk applications in the past, present and future…

Your Expectations for this session are …
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Introduction of Financial Risk
Types of major Risks
Sub-categories of Risk
Major Bank Failures
Types of major Risks
Credit Risk:
This is one of the risks which has been shattering the financial firms. Credit risk denotes the risk
of default from the borrower’s end. The scenario or the event which would cause the borrower
to default would be referred to as Credit event.

Market Risk:
This risk deals with the adverse price fluctuations and volatility of the markets. The earnings of a
financial institution would become uncertain due to the changes in the market conditions. There
are multiple factors which would cause this to happen such as changes in political scenario,
interest rates, equity and FOREX prices etc.,

Operational Risk:
Operational Risk is the occurrence of loss due to inadequate or failed internal processes,
incorrect decisions made by the senior management, or from external events. It also includes the
exposure to litigation from all aspects of a firm’s activities.

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Sub Categories of Risk and Measurement approaches
Risk
Credit Risk
Sub-Categories
Measurement Approaches
Default Risk
• Standardized Approach
• Internal Ratings Based Approach
Spread Risk
Legal And Compliant Risk
Operational Risk
• Basic Indicator approach
• Standardized Approach
• Internal Measurements Approach
System Risk
People Risk
Interest Rate Risk
Liquidity Risk
Market Risk
• Standardized Approach
• Internal Model Approach (IMA)
Forex Risk
Equity Risk
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Major Financial failures post Great Depression
S.No
Bank
Year
Reason
1
Herstatt crisis
1974
Herstatt risk
2
Savings and Loan crisis
1984
Slump in real estate market and lack of proper
regulations
3
Sub-Prime Mortgage Crisis 2008
4
European Debt Crisis
BFS-US SSDU Research
2009 –
Till date
Sudden slump in real estate market
Unprecedented growth in the government debt
levels
Introduction to Basel and Role Of Quality Assurance
A brief history of Basel Committee
Basel I Capital Accord
Basel II Capital Accord
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Introduction to the Basel Accords
Basel I (1988-2003)
 Minimum Capital Requirement
 Standardized Approach
Minimum
 Reasons for failure
Capital
Basel II (2004 – Present)
 Enhancements to Basel I
 Three Pillars
 Internal Based Approaches
 Reasons for failure
Supervisory
Committee
Market
Discipline
Foundation and
Advanced
Approaches
Monitoring Risk
Models
Data
transparency
Credit, Market
and Operational
Risks
Stress and VaR
estimates
Disclosures
Fig 1 – Pillars of Basel II
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Transformation of QA profile during Basel I
Scope of QA during Basel 1
QA Phases
Scope of QA during Basel 1
The following are the key areas of testing during Basel 1:
• GUI applications which would compute Tier Capital , Regulatory Capital and
the Adequacy ratio.
• Systems which would ensure that the Credit Risk weightage is grouped into
the appropriate buckets
• Applications to compute Collateral and margin requirements
• Applications which are designed to report the exposure limits to authorities
• Data migration for the firms involving in Mergers and Acquisitions. Basel 1
compliance post migration had to be validated.
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QA Phase 1
QA
• Dedicated testing teams were formed
• Test management was carried out in Excel
• Testers were confined to black box manual testing predominantly
Value Add
• With the existing skillset of testers, their role was confined to GUI testing of
risk applications which would compute Credit RWA parameters.
• This validation was done using both Standardized and IRB approaches
Limitation
• Lack of proper estimation techniques
• Lack of test management tool
• Limited scope to do Root Cause Analysis
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QA Phase 2
QA
• Simple, Medium and Complex estimation Model
• Test management tools
• Testers were exposed to Data Base Testing
Value Add
• Business had means to make a budget forecast with estimation models handy
• To ensure that risk ratings from external entities have been correctly loaded
into Banks’ DB and the computations of capital were accurately done
• Test Management tools proved to be handy for efficient defect management
Limitation
• Testers had only basic SQL knowledge
• Advanced features of excel were not explored to support the testing activities
• Automation was not yet in place for functional and GUI testing
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QA Phase 3
QA
Value Add
Limitation
•
•
•
•
The role of Excel as a data management tool was recognized globally
Testers became proficient in handling the Database
Licensed test management tool
Adapt to new Test Life cycles
• Back testing of Stress and VaR risk estimates could be validated by using excel
• Test case preparation process had been accelerated due to the query generator
templates
• Automation tools significantly cut down the repetitive manual effort
•
•
•
•
Advanced reporting was consuming lot of manual effort using Excel
Time to market was significantly high
Testers were confined to using excel formulae and formatting features
The interaction between multiple entities was not established
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Transformation of QA profile during Basel II
Scope of QA during Basel 2
QA Phases
QA Progression into Two dimensional
Are we there yet???
Scope of QA during Basel 2
The following are the additional validations done on top of Basel 1:
• Applications which would compute Operational and Market Risk charges using
various approaches.
• Systems to validate the efficiency of Internal risk models and Back testing
• GUI applications to validate the disclosure content and reporting format
• Validation of applications migrating to advanced DB versions and ensuring
system is Basel 2 compliant post migration.
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QA Phase 4
QA
•
•
•
•
Testers had become conversant with the VBA scripting
Testing was carried over in iterative phases using AGILE model
Testers had been exposed to various DBs
Interfacing between tools became the most happening phenomena
Value Add
• Time to Market due to AGILE model
• The new risk estimates barging into the market due to the advancement in
Statistical and Probabilistic models could be validated better
Limitation
• Validation of applications containing volumes of data proved to be a huge
challenge with regards to the execution and reporting
• Performance issue
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QA Phase 5
QA
• Data warehouse testing is considered as specialized testing
• QA was involved in validating the data transformation as per the business rules
• Performance and Load testing of GUI has started gaining prominence
Value Add
• Data volume issues have been addressed using DWH
• Back end testing of the firms involved in the mergers & acquisitions was
possible
• Extra level of Data transformation validation
Limitation
• Across the testing phases, multiple vendors were involved in bits and pieces. No
vendor had the complete information about the system from the business
perspective
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QA Phase 6
QA
•
•
•
•
Test Centre of Excellence
Business Intelligence
Advanced ETL implementations
Introduction to Cloud testing and Mobile banking
• Vendors could offer one stop comprehensive solutions
• Reports could be generated using tools in a customizable format
Value Add
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Are we there yet???

Will the testers be able to comment upon the efficiency of Backtesting
implemented and make suggestions to the business?
Will the firms involve QA in the business oriented discussions such as IRB
Approaches to be followed (Foundation, Advanced) or the frequency of the
Stress tests?

Will QA be able to recommend efficient Stress and VaR scenarios to the
firms?

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Language of Business and QA
Scenario 1
QA : Market Risk Charge is zero for some records in Source system
Business : All the records reported are for historical data. Source is Basel1
compliant and VaR estimates will not be available. IMA implemented only after
1998.
Scenario 2:
QA :There are 100 mismatches in the Location field between Source and Target.
Business : This is branch roll up which is common across OTC instruments. Not
an issue. BAU
BFS-US SSDU Research
Anticipated Role of QA during Implementation of Basel III
Introduction to Basel Capital Accord III
QA with Key Objectives of Basel III
QA at the end of Basel III
Introduction to the Basel III
Basel 3 (2012-2019)
 Enhancements to Basel II
 Areas of concerns
Minimum
Capital
• Introduced new
liquidity ratios and
buffer components
Supervisory
Committee
• More emphasis
on Supervision and
quality of stress
and VaR models
Fig 3 – Changes done to Basel II
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Market
Discipline
• New disclosures
added
QA with Key Objectives of Basel III





To ensure that the firms focus on their core areas and cut down the
infrastructure costs
To ensure that the Stress data is centralized and quality of the risk estimated
are improved
To ensure that the performance of the risk applications is up to the
international standards and the system down time is significantly reduced
To improve upon the quality of reporting
To ensure that there are no reciprocating effects due to other policies such as
Dodd-Frank, Solvency II, especially in case of US firms
BFS-US SSDU Research
QA at the end of Basel III
Testing
Technical
Domain
Business Tester
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Best Practices









Standard Templates
Checklists
Reuse
Scripting knowledge
Documentation
Test Management
Process Adherence
Configuration Management
Knowledge Management
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Summarization
Quick recap…
Quick recap
 Introduction to Financial risk & categorization
 Basel I, II & III
 Progression of QA from Basel I to beginning of Basel III
 Best practices
 Tester’s profile in Basel III
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Closure
Did we meet the objectives?
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References
 http://bis.org
 Infosys project experience
 Infosys resources (www.infosys.com)
Q&A:
Murthy_Yerraguntla@infosys.com,
Srilatha_Vasu@infosys.com,
Nagendrann@infosys.com
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